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(Editor's Note: Today's guest columnist is Bill Luby, a private investor and the author of the VIX and More blog.)
There is a quiet revolution going on in the investment world. Volatility, once seen as the domain of institutions and options traders, is about to enter the mainstream and by the end of the year should be well on its way to becoming established as a mainstream asset class.
The catalyst behind this development is the growing acceptance of exchange-traded products ) based on volatility. First launched two years ago this month, the initial products in this space were exchange-traded notes (ETNs) which were based on a basket of CBOE Volatility Index (VIX) futures. Two years later there are fifteen volatility-based ETNs and ETFs which account for $2.3 billion in assets.
Volatility-based ETPs can best be understood when they are examined in the context of term structure exposure and sensitivity to volatility. Term structure is a critical component of volatility-based ETPs and is often misunderstood. Over 99% of the volume in volatility-based ETPs comes from the 14 ETPs whose holdings include VIX futures. Most of these VIX-based ETPs target a portfolio of VIX futures with a constant weighted average maturity of either one month or five months. While the average term structure of VIX futures five months out is flat, about 80% of the time the second month VIX futures are more expensive than the front month VIX futures (a situation called "contango") with the result that in a typical month, the second month VIX futures can be expected to be priced at an average of about 5% higher than the front month VIX futures.
The persistent contango in VIX futures means that in the course of rebalancing, the one-month ETPs incur a "negative roll yield" of 5% to maintain that constant average maturity.
Negative roll yield is the main reason why VXX has underperformed VXZ and the VIX since its launch two years ago.
Related to the term structure issues, not all ETPs have the same sensitivity to changes in volatility, with back months less sensitive than the front month. For example, on a daily basis the second month VIX futures only capture about 70% of the typical move in the front month futures. The back month futures capture an even smaller amount of that move, with the sixth month futures netting only about 40% of the move in the front month.
Seen in the context of term structure and other factors, some of the volatility-based ETPs are a better match for certain strategic approaches than others. Along these lines, perhaps the biggest development of all is the recent launch of two ETPs that are appropriate for buy and hold investing. The first of these is XVIX, which holds a 100% long position at a five month target maturity in addition to a 50% short position in a one month target maturity. The resulting ETP has a limited exposure to volatility and is therefore a relatively conservative investment, yet is positioned to take advantage of the 80% of the time the VIX futures are in contango.
The other recently launched ETP that has a great deal of buy and hold potential is XIV, which is essentially an inverse version of VXX. Like XVIX, gains in XIV are likely to come from VIX futures contango. Unlike XVIX, XIV is fully exposed to a spike in volatility. For this reason, XIV is only suitable for aggressive investors who are able to trade XIV in the context of a strong risk management plan.
Investors looking to take advantage of a spike in volatility can do so with a wide variety of products. Long-term positions should focus on minimizing exposure to contango and seek out ETPs with a five month target maturity, such as VXZ. For short-term holdings and day trading, contango is less of a concern and direct exposure to volatility is more important, which makes VXX and the double ETN, TVIX, more appropriate choices.
In sum, volatility is moving into the mainstream and becoming accepted as an asset class. The most recent crop of volatility-based ETPs has accelerated that process with vehicles that are suitable for buy and hold investors and also take advantage of the persistent contango in VIX futures.
These products are frequently misunderstood, but among the group are excellent alternatives for hedging, diversification and speculation. In short, the investment opportunities are substantial enough that it makes it worth the time and effort to learn the idiosyncrasies of these volatility ETPs.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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